January 12, 2011

Executive pay: what’s wrong with this picture?

A reader (SM Forsman) asked yesterday about the role of compensation in revolutionizing the world of work. An interesting question. The current situation might be summed in the following rough but fairly accurate picture:

On the left hand side, we can see what has happened to corporate performance in the last 45 years. In a study of 20,000 US companies from 1965 to date by Deloitte’s Center for the Edge (the Shift Index), we see a disastrous decline in performance overall in this peiod::

The rate of return on assets of these firms has fallen by 75%.

The life expectancy of these firm has fallen from around 70 years to less than 15 years, and is heading towards 5 years, unless something changes.

Meanwhile, on the right hand side, we can see what has happened to compensation. While corporate performance has been on this sharp decline, executive compensation has been increasing astronomically. Whereas in 1965, executive compensation was 24 times what the typical worker made, studies show that today executive compensation is a staggering 275 times what the typical worker makes.

In a more detailed study of the growth of U.S. executive pay during the period 1993-2003 by Lucian Bebchuk and Yaniv Grinstein, pay grew much beyond the increase that could be explained by changes in firm size, performance and industry classification. Had the relationship of compensation to size, performance and industry classification remained the same in 2003 as it was in 1993, mean compensation in 2003 would have been only about half of its actual size. In other words, executives were receiving increases in compensation that were twice what would have been justified by performance.

Meanwhile, during the period, compensation for workers has remained basically unchanged. Studies show that real average hourly earnings (excluding fringe benefits) now stand roughly at 1974 levels. Since the cost of health and education has been increasing rapidly, the actual standard of living of most people has been on the decline.

“Corporate boards appear to routinely use compensation peer groups to artificially inflate pay for their chief executives, helping to contribute to the cascading increases in executive compensation over the last several years, according to an academic study on corporate governance.”

The common answer as to why chief executives are paid so much money is that boards want to “retain talent” and fear losing their chief executive to a competitor. Compensation committees on boards hire consultants to advise them on how much other chief executives at rival companies are paid to make sure that they are not undercutting their own top executives.

“Boards do look at labor market practices, so this is not an entirely corrupted process,” Ms. Yang told DealBook. “They do look at industry, they do look at size, the past talent flows, their visibility in everything, so that’s still the major part in the peer choices.”

“But on top of that, if you can choose between company A or company B, which are pretty similar except that A pays their C.E.O. a little bit more generously than B, the board members tend to choose the slightly better paid company as the peer,” Ms. Yang said.

The research showed that from 2006 to 2007 this selection bias toward the higher-paying peers led to a 10.7 percent increase in the median pay for chief executives for more than 600 companies in the Standard & Poor’s 500-stock index and S.&P. MidCap 400 index, equating to a median pay increase of $470,000.

“If we see this each and every year, the compensation is going to go up and up,” Ms. Yang said. “You can call this an upward spiral, you can call this ratcheting up, but yes, it is going to go up.”

What about the workers?

How should we view the disparity between executive compensation which has been soaring and workers' pay which has been flat for some 45 years?

In an article the current issue of Atlantic magazine by Chrystia Freeland about the new super-rich top executives take a brutally realistic view of the situation.

In a recent internal debate in a large hedge fund, one senior executive said that the hollowing out of the American middle class didn’t really matter. If the world economy lifted four people in India and China out of poverty while one American drops out of the middle class, “that’s not such a bad trade.”

The Michael Splinter, CEO of a green tech firm said: “I can get workers anywhere in the world. It is a problem for America, but it is not necessarily a problem for American business… American businesses will adapt.”

Nor was the CFO of an internet company particularly sympathetic to the plight of the American middle class. “If you’re going to demand 10 times the paycheck, you need to deliver 10 times the value. It sounds harsh, but maybe people in the middle class need to decide to take a pay cut.”

One can admire the objectivity of this analysis, while at the same time asking: when will similarly brutal objectivity be applied to executive compensation?

If executive pay was pegged to corporate performance, executives should be getting about a quarter of what they received forty years ago, rather than an astonishing increment of 275 times worker pay. In other words, on this basis, executive compensation is about forty times higher than it ought to be, if it was based on performance.

Capitalism 2.0 vs Capitalism 3.0

The discussion so far has been dealing with the Fortune 500, which are mostly proceeding along the lines of Capitalism 2.0 i.e. maximizing value to shareholders. These are the Walmarts and GEs of this world—companies which are doggedly tweaking their value chains and whose share price has struggled for at least the last decade.

The picture is of dramatically different if we look at companies practicing Capitalism 3.0, i.e. shareholder capitalism where the object of the firm is to delight the client. These are firms like Apple and Amazon, with increments in share value of ten- to fifteen times over the last decade.

If firms were performing like Apple and Amazon, then there would be plenty of room—and justification—for substantial increases in both executive and worker compensation. All of which underlines the need for organizations to move into Capitalism 3.0 without delay.